Part 1 Finance Textbook - Ch. 1 and Ch. 2

Three areas of finance.

Financial Management (Corporate Finance), Capital Markets, Investments

Corporate financial decisions profoundly impact the firm's stock price, which is determined in the capital markets and influences investment decisions by individuals and institutions.

Investors need to understand corporate finance principles to analyze a company's financial health and assess the value of its securities, which they then buy or sell in capital markets.

Financial institutions operate within capital markets and provide the necessary mechanisms for corporations to raise funds and for investors to trade securities, thus connecting financial management and investment activities.

Chief Financial Officer

generally a senior vice president and the third-ranking officer, is in charge of accounting, finance, credit policy, decisions regarding asset acquisitions, and investor relations, which involves communications with stockholders and the press.

Limited Liability Companies

type of organization that is a hybrid between a partnership and a corporation

S corporation

A special designation that allows small businesses that meet qualifications to be taxed as if they were a proprietorship or a partnership rather than a corporation.

Sarbanes-Oxley Act

A law passed by Congress that requires the CEO and CFO to

certify that their firm’s financial statements are accurate.

Happened after the scandals of Enron and WorldCom.

Proprietorship

Owned by one individual.

Unlimited liability

Easiest and least costly to form

Limited to the owners funds and loans

Business income treated as personal income of the owner and taxed at individual rates (pass-through taxation).

Limited to the life of the owner

Partnership

Owned by two or more individuals

Liability

• General ______: Unlimited liability

• Limited ______: Liability relies on the amount of investment put in. Typically they have no management control

Easy to form, but requires partnership agreements

More capital raised from partners’ contribution. Still limited to their assets.

Business income is passed through the individual partners and taxed at personal income.

Dissolves or is re-organized if partner leaves or dies.

Corporation

Separate legal identity, owned by shareholders and ownership represented through stocks.

Limited Liability

Harder and costly to form, requiring legal processes.

Capital is raised through issuing stocks, including Initial Public Offerings (IPO) in the stock market.

Double Taxation (taxed on profit and shareholders pay tax on dividends received) for C ____, not S _____.

Perpetual existence, independent from owners. Ownership is transferrable.

Intrinsic Value vs. Market Price

Intrinsic Value

An estimate of a stock’s “true” value based on accurate risk and return data. Can be estimated but not measured precisely.

Market Price

The perceived value of a stock but possibly incorrect information as seen by the marginal investor.

Price is determined by supply and demand.

Marginal Investor

An investor whose views determine the actual stock price.

Equilibrium

Intrinsic Value = Market Price

Investors are indifferent between buying and selling stock because Market Price reflects its true worth.

Corporate Governance

Establishment of rules and practices by Board of Directors to ensure that managers act in shareholders‘ interests while balancing the needs of other key constituencies.

Should managers estimate intrinsic values or leave that to outside security analysts?

Explain.

Yes, they should, as it helps

• make informed decisions on capital budgeting, financing, and operating decisions.

• understand market perceptions

Managers are better positioned to know the true facts and consequently should lead the process of estimating and enhancing intrinsic value.

If a firm could maximize either its current market price or its intrinsic value, what would stockholders (as a group) want managers to do?

Maximize Intrinsic Value

Since it is the true, long-run economic worth of the company.

Maximizing current market price alone might lead to short-sighted decisions that do not align with the long-term interests of shareholders.

Corporate Raiders

Individuals who target corporations for takeover because they are undervalued.

Hostile Takeover

The acquisition of a company over the opposition of its management.

What are three techniques stockholders can use to motivate managers to maximize their stock’s long-run price?

Managerial Compensation Plans, Direct Intervention by Shareholders, Threat of Hostile Takeover

Why might conflicts arise between stockholders and debtholders?

Stockholders benefit from higher returns and are generally willing to take on more risk for greater potential gains.

Debtholders have a fixed claim and primarily seek the security of their principal and interest payments, thus preferring lower risk and stable cash flows.

How might astute bondholders react if stockholders take on risky projects?

Demand higher interest rates on future debt issuances to compensate for the increased risk.

Insist on stronger bond covenants, which are contractual clauses designed to protect their interests by restricting the company's actions, such as limiting additional debt, dividend payments, or asset sales.

How can bondholders protect themselves from managers’ actions that negatively impact bondholders?

Covenants - designed to protect their interests by restricting the company's actions, such as limiting additional debt, dividend payments, or asset sales.

Shareholder Wealth Maximization

The primary financial goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm’s common stock.

Is maximizing shareholder value inconsistent with being socially responsible?

No, maximizing shareholder value is not necessarily inconsistent with being socially responsible.

In the long run, companies that prioritize social responsibility often enhance shareholder value by building a strong reputation, attracting and retaining talent, fostering customer loyalty, and mitigating regulatory and environmental risks.

Business Ethics

Moral principles and values that guide decision-making and behavior in the business world, influencing how companies and individuals interact with stakeholders, operate legally, and contribute to society.

Can a firm’s executive compensation plan lead to unethical behavior?

Yes, a focus on immediate results can undermine ethical considerations and sustainable business practices.

Limited Liability Partnership

Similar to an LLC but used for professional firms in the fields of accounting, law, and architecture. It provides personal asset protection from business debts and liabilities but is taxed as a partnership.